copyright: m. s. humayun1 financial management lecture no. 34 optimal capital structure – impact...

Copyright: M. S. Humayun 1

Financial Management

Lecture No. 34

Optimal Capital Structure – Impact of Debt on Firm Value & WACC Graphs


Recap of WACC & Firm Risk• WACC % = rD XD + rE XE + rP XP . 3 Basic Forms of Raising Capital: D=Debt, E=Common Equity, & P=Preferred

Equity. Uses Required ROR’s adjusted by Taxes and Transaction Costs. “x” represent fractions of MARKET VALUES of Debt or Equity. Should NOT use the Book Values from Financial Statements used in Financial Accounting.

– Two Ways to Raise Equity Capital: (1) Retained Earnings which is cheap way to raise equity AND (2) New Stock Issue which is more costly

– Two Ways to Calculate rE (Required ROR on Equity): (1) Gordon’s Formula for Stock Pricing : rE = (DIV1/Po) + g AND (2) CAPM Theory / SML : rE = rRF + (rM – rRF)Beta

• Total Stand Alone Risk of Firm = Business Risk + Financial Risk• Business Risk = Standard Deviation of ROE of Un-levered Firm

– Operating Leverage (OL) = Fixed Cost / Total Cost. OL increases Business Risk. Small Change in Sales Causes Large Change in Operating Income & ROE. OL can be Good when Sales > Breakeven.

• Financial Risk = Total Risk for Levered Firm - Business Risk– Financial Leverage = Market Value of Debt / Market Value of Total Assets = D / (D+E): FL increases Financial Risk.

Small Change in EBIT Causes Large Change in ROE. FL can be Good when EBIT/Assets > Interest.– Leverage Rises. Financial Distress & Higher chance of Bankruptcy. Banks charge Higher Interest Rates.

Higher Cost of Debt. Higher Risk. Higher Beta. Higher Required Return on Equity ( rE ). Higher Cost of Equity.


Recap of Capital Structure Theories• Miller Modigliani (MM) Theory – Case of Ideal World & Efficient Markets

– Capital Structure, DEBT, & Corporate Financing have NO AFFECT on Capital Budgeting, MARKET VALUE OF FIRM (V), NPV, & Investment Decisions

– Remember that in Efficient Markets, the Fair Value of a Firm (calculated using NPV) is approximately equal to the Market Value. The Firm’s Value is determined by the Future Cash Flows generated by the Firm (or Real Assets) and NOT by the way the cash flows are split or divided amongst the Debt and Equity Holders.

– Market Value of Firm = V = EBIT / WACC . As Debt Increases, Risk Increases so rD and rE and WACC should increase. BUT Debt is cheaper than equity (recall Risk Theory) so as Debt Increases, WACC should decrease ! Net Effect is No Change in WACC and No Change in Value !

– Major Assumptions: No Taxes, No Bankruptcy Costs, Equal Information, Efficient Markets• MM Theory with Taxes

– Corporate Tax favors Debt Financing because of Interest Tax Shield. Personal Tax favors Equity Capital. Net Effect is that Taxes favors raising Capital through Debt Financing.

• Tradeoff Theory (With Taxes & Financial Distress / Bankruptcy)– When Excessive Leverage (Debt or Borrowing) then Bankruptcy Costs begin to Outweigh Benefits of Interest Tax

Shield or Savings. At first, Firm’s Value Rises because of Interest Tax Savings but as Debt increases, the Value reaches a Maximum Point (where WACC is minimum) and then at excessive Debt levels, the Value begins to fall.

• Signaling Theory (Market Signals)– New Equity Issue gives signal to Market Investors that Firm’s financial future looks bad so Market Price of Stock often

falls. Cost of Equity and Required ROR on Equity (rE ) increases.

– Debt Financing signals strong future earnings. Firms should save some Spare or Reserve Debt Capacity in case they find an attractive Project or Investment.

– Save Some Spare or ReserveDebt Capacity for good investment opportunity. Give right signal to market.


Effect of Leverage on Cost of Debt & Equity • Effect of Financial Leverage (or Debt) on Cost of Debt (rD):

– At Low Leverage, Increase in Leverage leads to Slight Increase in Overall Risk and Return of Firm.

– At Higher Leverage, Risk of Financial Distress & Bankruptcy. Banks Raise Interest Rate Charges. Cost of Debt Rises Faster. Required ROR of Firm’s Debt Holders (rD ) Rises Faster.

• Effect of Financial Leverage (or Debt) on Cost of Equity (rE): – Firm’s Total Risk Rises Slowly at Low Leverage and Faster when

Leverage becomes Excessive and Risk of Financial Distress arises. Firm’s Stock Beta Rises. Firm’s Stock Required ROR (rE ) Rises.

• WACC = rDxD + rExE (assuming no Preferred Equity): – Effect of Debt on WACC changes depending on choice of Theory.– Pure MM Theory: WACC does Not Change. WACC curve is Flat.– Traditionalist Theory (and Tradeoff Theory): WACC curve is broad U-

shaped Parabola with Minimum WACC point.


Effect of Leverage on WACC

• WACC: Effect of Debt on WACC Changes.– Pure MM View (Ideal Efficient Markets): No Taxes

and No Bankruptcy Costs. Debt increases Risk BUT is also Cheaper than Equity so NO Net Effect on WACC. So, Change in Debt has no effect on WACC and Value. WACC curve is Flat.

– Traditionalist View (Tradeoff Theorists, Real Markets): Combined Effect of Taxes and Financial Distress / Bankruptcy Costs is a Flat U-Shaped WACC Curve with a Minimum Point which represents the Optimal Capital Structure (ie. Best Debt Ratio for the Firm).


Pure MM Theory - Ideal MarketsWACC Graph

WACC = rDxD

+ rExE

rE = Cost of Equity

=WACC+D/E (WACC-rD)

rD = Cost

of Debt

Cost of Capital (%)

Debt / Equity = D/E = xD / ( 1- xD )

rE

rD

100% Equity Firm

Financial Risk. Higher Required Return on Equity.

Higher rE


MM View - Ideal Markets Example• A 100% Equity Firm (or Un-levered) has Total Assets of Rs 1000. It has a WACCU of 21% (=

rE,U ) and rD,U of 10%. It then adds Rs 400 of Debt. Financial Risk increases rD,L of Levered Firm to 13%. What is the Levered Firm’s rE,L and WACCL ?

• Assuming Pure MM View - Ideal Markets. Total Market Value of Assets of Firm (V) is UNCHANGED. VU = VL . Also, WACC UNCHANGED by Capital Structure and Debt. WACCU

= WACCL = 21%

• rE,L =WACC + D/E (WACC - rD,L) = 21% + 400/600 (21% - 13%) = 26.3%

• rE,L= (WACC - rD,L xD)/ xE = (21% - 13% (400/1000)) / (600/1000) = 26.3%

• Cost of Equity for Levered Firm = rE,L = Risk Free Interest Rate + Business Risk Premium + Financial Risk Premium. rE,L Increases because Required ROR for Stock Increased because of Financial Risk


Pure MM Ideal Markets - Example• Example: Assuming Pure MM Theory with Ideal Efficient Markets

where Total MARKET VALUE of Assets of Firm (V =D+E) is UNCHANGED by the Capital Structure (and Leverage). Given the following Data on Leverage and Cost of Capital:

Debt (D) Interest (rD) Equity Cost of Equity

(E = V-D) (rE= (WACC- rD xD)/ xE)

Rs 0 (=V) 0 Rs 1000 21% (=WACC) Un-Levered

Rs 200 10% (rRF) Rs 800 (21% - 10%(0.2))/0.8 = 23.75%

Rs 300 11% Rs 700 (21% - 11%(0.3))/0.7 = 25.3%

Rs 400 13% Rs 600 (21% - 13%(0.4))/0.6 = 26.3%

Rs 500 15% Rs 200 (21% - 15%(0.8))/0.2 = 45%

• Problem: In Real Markets, Total Market Value of Firm (V) DOES CHANGE as Leverage Increases.


Tradeoff Theory Graph – Linked to Traditionalist Theory of

Leverage & Optimal Capital StructureSlightly Leveraged Firm: Interest Tax Shield Benefit. Total Return to Investors Rises so Stock Value Rises. Total Return = Net Income (paid to Shareholders) + Interest (paid to Debt Holders)Value of

Firm or Price of Stock

Financial Leverage = Debt / Assets = D/(D+E)

OPTIMAL Capital Structure - MAXIMUM VALUE & MINIMUM WACC

Excessively Leveraged Firm: Threat of Bankruptcy has Real Costs. Less Investor Confidence and Lower Share Price.

Firm Remains 100% Equity (Un-Levered)


Traditionalist Theory - Real MarketsWACC Graph

WACCL = rD(1-Tc)xD + rExE

rE,L = Cost of Equity = WACCU

+ xD(WACCU -rD) (1-TC)

rD = Cost of Debt

Cost of Capital (%)

Debt / Equity = D/E = xD / ( 1- xD )

rE

rD

100% Equity Firm

Bankruptcy Risk & Costs. Higher Required Return on Equity. Steeper Rise.

Interest Tax Shield Advantage

Optimal Capital Structure Note: xD = D / (D+E)


Traditionalist View - Example• Same Example: A 100% Equity Firm (or Un-levered) had Total Assets of Rs 1000. It had a WACCU of 21% (=

rE,U ). It then added Rs 400 at a Cost of Debt rD,L (for Levered Firm) of 13%. What is the Levered Firm’s rE,L and WACCL ? Given Data for rE , Corporate Tax Rate of 30% on EBT, and EBIT = Rs 300.

• Traditionalist View is based on Practical Reality. Leverage provides Interest Tax Savings (or Shield) but also Increases Financial Risk. Excessive Leverage leads to Bankruptcy Risk. Increase in Risk will Change Value of Firm and WACC.

• Now rE is based on Observed Data. And Equity Value (E) is Based on Simple Income Statement Formulas.

• Traditionalists Formulas for Equity: E = NI / rE,L

Note: NI = EBIT - Interest - Tax = EBT - Tax

NI = (EBIT - xD rD ) (1 - Tc).

rE,L = WACCu + xD (WACCu - rD ) (1 - Tc).

• Traditionalists Formula for WACC: WACCL = xD rD (1 - Tc) + xE rE .

(1-Tc) is the Tax Discount Factor.

• Note: V = D + E xD = D /V = D / (D+E) xD + xE = 1

V = Market Value of Firm D = Market Value of Debt

E = Market Value of Equity

xD = Fraction of Debt = A Measure of Leverage

copyright: m. s. humayun1 financial management lecture no. 34 optimal capital structure – impact...

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